Economists Can’t Be Trusted on Tax Plans: Laurence Kotlikoff

By Laurence Kotlikoff -
Oct 25, 2011

The presidential campaign has just
begun, and it’s already making me queasy. It’s not the smug
politicians claiming magical job creation powers or special
connections with the almighty. It’s the economists who produce
misleading analyses of the candidates’ proposed policies.

Herman Cain’s 9-9-9 tax plan is a case in point. My last
column pointed out that his plan would hit the superrich --
those with lots of wealth, but little or no labor earnings --
right in the solar plexus, dramatically lowering their
sustainable living standards. The day after the column appeared,
the Tax Policy Center, a joint venture of the Urban Institute
and Brookings Institution, released a widely quoted study
suggesting exactly the opposite.

I’m not surprised. The Tax Policy Center has first-rate
economists, but they knowingly use wholly inappropriate
distribution analysis also employed by Congress’s Joint
Committee on Taxation, the Congressional Budget Office, the
Congressional Research Service and the Treasury’s Office of Tax
Analysis.

All five groups of tax experts take annual income as a
measure of a household’s economic standing and evaluate the
progressivity of tax proposals by dividing annual taxes by
annual income. This is problematic, in large part because people
don’t live for just one year. Their incomes and the taxes on
that income change over their lifetimes.

Relying on a snapshot of income alone can be misleading in
various ways.

Rich or Poor

First, someone can be extremely rich and temporarily have
very little income and thus be treated as extremely poor. If
Warren Buffett loses as much money as he makes this year playing
the market, his income will be zero and he’ll be classified as
dirt poor, even though he has some $50 billion in wealth.

Second, two people with the same lifetime incomes and
spending capacity can have dramatically different patterns of
earnings over their life cycles. Joe may make most of his money
when young, and Sally may make most of hers when old. Should
distributional analysis, performed when both are young, treat
Joe as rich and Sally as poor, when they actually have the same
lifetime resources?

Third, grouping people of different ages together on the
basis of income compares apples with oranges. An otherwise broke
65-year-old earning $200,000 a year who is about to retire is in
a very different resource situation than an otherwise broke 35-
year-old who earns the same amount, but will work 30 more years.
The 65-year-old has very low sustainable spending power compared
with the 35 year old.

Common sense, confirmed by theory, provides a prescription
for evaluating tax burdens. Simply compare each household’s
spending power -- the buying power of its remaining lifetime
resources -- before and after the proposed policy change. A
household’s lifetime resources are current wealth plus the
present value of current and future labor earnings.

For example, if we hit Buffett with an immediate 20 percent
wealth tax, we know we’ve reduced his lifetime spending power by
20 percent. This is true regardless of whether Buffett intends
to spend his money on himself, on gifts to his children or on
charities. However and whenever Buffett spends his money, he has
one-fifth less to spend.

Now suppose we tax Buffett’s spending power not by taking
away any of his money, but by imposing a 25 percent sales tax
that raises the prices he, his children and his charities must
pay to buy things. This leaves Buffett in the same boat. The
purchasing power of his $50 billion drops 20 percent because 20
cents of every dollar Buffett or his beneficiaries spends goes
toward taxes and 80 cents goes to consumption. (Note that 20
cents divided by 80 cents equals a nominal 25 percent sales-tax
rate.)

Wealth Tax

So a 25 percent sales tax, which raises the consumer price
level by 25 percent, is precisely equivalent to a 20 percent
wealth tax. In fact, the timing of the tax hit is identical as
well. The moment the sales tax goes into effect, prices rise by
25 percent and the purchasing power of the $50 billion drops by
20 percent.

I’m using the example of a 25 percent sales tax for a
reason. The Tax Policy Center says that 9-9-9’s “three taxes
combined are equivalent to a 25.38 percent national sales tax.”
But the center isn’t going public with the fact that 9-9-9 is
taxing wealth by 20 percent.

Instead it’s telling us to locate Buffett in an income
distribution table that suggests that people with high income
will see their taxes fall dramatically. Or, if we think
Buffett’s a low-income guy, at least in the short run, we can
place him among the poor and convince ourselves that his taxes
will rise. The center’s analysis assumes that the rich spend no
money out of the principal of their wealth, so it naturally
understates how much sales tax the rich will pay.

This is truly an economic theater of the absurd. Here we
have Cain, the darling of the Tea Party, proposing a huge wealth
tax, which is a goal of the Occupy Wall Street protesters. We
have Cain chastising Occupy Wall Street for demanding what he’s
proposing. And we have the Occupy Wall Street folks convinced
he’s a capitalist tool.

Some observers, such as U.S. Representative Nancy Pelosi, a
California Democrat, will still argue that a sales tax is
regressive, on the grounds that the poor spend a larger share of
their income. Data on how much households consume, though, are
skewed by the fact that millionaires and billionaires who spend
a lot out of their wealth can often fall into the low-income
category.

The interesting question here is why the congressional
agencies, and their copycats, refuse to analyze changes in tax
burdens correctly. One answer is that doing so would require
admitting they’ve been serving up nonsense for decades. Another
is that members of Congress can’t be re-educated. A third is
that telling the truth about tax distribution effects would
actually lead to consensus on tax reform and threaten plenty of
vested interests, including those of the economists who are
making a living producing misleading calculations and disserving
the public.